Changes to the Estate Tax System: What You Need to Know in 2010

01.29.2010

Summary

Effective January 1, 2010, the federal estate and generation skipping transfer taxes have been repealed for a period of one year. Effective January 1, 2011, both taxes will be reinstated albeit with lower exemption amounts and higher rates than under the 2009 tax regime. In light of these changes, you should consider reviewing your estate plan to determine if any revisions are appropriate.

The federal gift tax remains in place with the existing lifetime exemption of $1 million and the annual exclusion amount of $13,000. However, the maximum gift tax rate for gifts made in 2010 has been lowered from 45% to 35%. These changes also include a one-year partial repeal of the rules allowing a step-up in basis on death of the property owner, which could result in significant income tax consequences for persons inheriting property in 2010.

It was widely expected by practitioners and commentators that Congress would act to prevent repeal of the estate and generation skipping transfer taxes and the changes to the gift tax prior to January 1, 2010. The failure of Congressional action to materialize has caused considerable uncertainty on how to proceed with estate planning in 2010 and beyond and may cast some doubt on the efficacy of some estate planning arrangements presently in place. To further cloud the picture, Congress is considering reinstating the 2009 estate tax system retroactive to January 1, 2010.

Background

The current changes have their roots in a law enacted by Congress in 2001 to institute a gradual repeal of the estate tax by phasing it out between 2001 and 2009 and then completely repeals the estate and generation skipping transfer taxes in 2010 for one year. Effective January 1, 2011, both taxes will return with lower exemption amounts and higher rates than the 2009 tax regime, as illustrated in the chart below.

Many estate plans drafted over the last several decades anticipate the existence of a some kind of estate tax in determining the timing and amount of allocations between a surviving spouse and the surviving children, for instance. Also, the generation skipping transfer tax has served as a significant impediment to making large gifts to grandchildren because it effectively doubles the amount of estate or gift tax that would otherwise be due upon such transfers. In fact, many estate plans have been structured around the generation skipping transfer tax exemption. Finally, many people were not anticipating the significant capital gains taxes upon sales of assets that could now result from the corresponding partial repeal of the automatic step-up in basis rules, which in some cases may represent an increase in total taxes over the prior estate and income tax system.

Congressional Action

Late in 2009 the House of Representatives passed a bill, H.R. 4151, which would have extended the 2009 estate tax exemption level and rate schedule into future years, thereby avoiding the 2010 temporary repeal. The Senate introduced several bills that would have the same effect, including S. 722 and S. 2784, but none of these were brought to the floor of the Senate for a vote before January 1, 2010. In spite of public statements from several lawmakers that the Senate would act quickly in 2010 to enact an extension of the estate tax retroactively, there has been difficulty obtaining the necessary votes to enact an extension. We will follow these developments with great interest in the coming weeks and months.

A second source of uncertainty regarding future Congressional action is the possibility of significant legal challenges being raised to a retroactive restoration of the estate tax now that it has been “repealed.”

In spite of these potential roadblocks, many commentators believe that Congress may pass retroactive legislation to extend the estate and generation skipping transfer taxes into 2010 and beyond, possibly by maintaining the 2009 exemption and tax rate levels.

Estate Planning Considerations

This would be an appropriate time to review your estate planning documents to see whether the estate tax repeal and modification of the income tax basis rules are significant enough to necessitate any changes to your existing estate plan. For instance, you may be affected by the estate tax repeal if any of the following scenarios, among others, apply to you:

You are married and your plan refers to assets passing “free from estate tax” to your children, or otherwise refers to your “estate tax exemption amount,” or uses similar terms in allocating assets between your spouse and your children. These documents may have the unintended effect of leaving much more or less to your spouse or children than you originally contemplated. This may especially be an issue if you have children from a prior relationship.

Your estate plan makes generation skipping gifts at death (e.g. to grandchildren). To the extent these gifts are measured by your unused generation skipping transfer tax exemption, they might not be effective when you die.

You might be affected by the lack of a step-up in basis upon your death for property you own, such as real property with a low basis. Often the treatment of such property within your estate plan depends on careful balancing between the income, estate, and California property tax consequences of gifting or bequeathing such property. A repeal of the estate tax coupled with the loss of the step-up in basis could significantly impact this decision.

It is important to remember that Congressional action to reverse the “repeal” of estate tax in 2010 may require further modifications to any changes you may make to your current estate plan. For this reason, some clients may wish to adopt a wait-and-see approach.